In Belk v Comm’r, 140 T.C. No. 1 (Jan. 28, 2013), a regular Tax Court opinion, the court held that a conservation easement that permits the parties to agree to “substitutions,” even if subject to certain limitations, is not eligible for a charitable income tax deduction under IRC § 170(h). The taxpayers had donated the easement, which encumbers a 184.627-acre golf course in the Olde Sycamore residential development, to a land trust in 2004 and claimed a $10.5 million deduction.

Article III of the conservation easement authorizes the landowner to remove land from the protection of the easement in exchange for adding an equal or greater amount of contiguous land to the easement, provided, inter alia, that in the opinion of the grantee: (i) the substitute land “is of the same or better ecological stability” as the land removed, (ii) the fair market value of the “easement interest” on the substitute land will be at least equal to or greater than the fair market value of the “easement interest” that encumbers the land to be removed (and that will be extinguished as a result of the substitution), and (iii) the substitution will have no adverse effect on the conservation purposes of the easement. Article III further provides that substitutions must be documented in a recorded amendment. Article VIII of the easement contains a typical “amendment clause” that authorizes the landowner and grantee to agree to amendments that, inter alia, are not inconsistent with the conservation purposes of the easement and will not result in the easement failing to qualify for a deduction under § 170(h).

The IRS argued that an easement that does not relate to a specific piece of property (a “floating easement”) is not eligible for a deduction under § 170(h) because it violates the perpetuity requirements. The Tax Court agreed, holding that the easement failed to satisfy the requirement that a tax-deductible conservation easement be a “use restriction granted in perpetuity.” See IRC § 170(h)(2)(C); Treas. Reg. § 1.170A-14(b)(2). “To conclude otherwise,” explained the court, “would permit petitioners a deduction for agreeing not to develop the golf course when the golf course can be developed by substituting [other property for] the property subject to the conservation easement.”

Citing to Treas. Reg. § 1.170A-14(c)(2) (the "restriction on transfer" requirement), the Tax Court noted that the regulations permit substitutions, but only under limited circumstances, including that an unexpected change in conditions has to have made continued use of the property for conservation purposes impossible or impractical. Treasury Regulation § 1.170A-14(c)(2) appears to provide that the restriction on transfer requirement will not be violated if the holder is permitted to extinguish (i.e., transfer) the easement in accordance with Treas. Reg. § 1.170A-14(g)(6), and that regulation sanctions substitutions in limited circumstances (i.e., in a judicial proceeding, upon a finding that continued use of the property for conservation purposes has become impossible or impractical, and with a payment of at least a minimum proportionate share of proceeds to the holder to be used “in a manner consistent with the conservation purposes of the original contribution”). The easement at issue in Belk did not limit substitutions to such circumstances. Although Treasury Regulation § 1.170A-14(c)(2) cross-references to Treasury Regulation § 1.170A-14(g)(5)(ii), the proper cross-reference is to -14(g)(6)(ii); the Treasury failed to update the cross-references when it finalized the proposed regulations in 1986.

The Tax Court found it immaterial that the land trust has to approve the substitutions, explaining:

There is nothing in the Code, the regulations, or the legislative history to suggest that section 170(h)(2)(C) is to be read to require that the interest in property donated be a restriction on the use of the real property granted in perpetuity unless the parties agree otherwise. The requirements of section 170(h) apply even if taxpayers and qualified organizations wish to agree otherwise.

The court also found it immaterial that Article VIII’s amendment clause prohibits the grantee from agreeing to amendments that would result in the easement failing to qualify for a deduction under § 170(h). The court explained that when there is a conflict between a specific provision (the substitution provision) and a general provision (the amendment clause), the specific provision controls. The court also noted that the parties’ intent controls and, by specifically reserving the right to agree to substitutions as provided in Article III, the parties evidenced an intent to neither prohibit substitutions nor limit them to the circumstances permitted under the Regulations.

In an IRS General Information Letter dated March 5, 2012, the agency advised that the contribution of a conservation easement that authorizes substitutions (sometimes referred to as "swaps") other in accordance with the extinguishment and proceeds requirements of Treasury Regulation § 1.170A-14(g)(6) will not be eligible for a federal charitable income tax deduction under section 170(h).

The Instructions to Schedule D for the Form 990, which
require nonprofits to report on their conservation easement transfer, modification,
and termination activities, explain that an easement is released, extinguished,
or terminated “when all or part of the property subject to the easement is
removed from the protection of the easement in exchange for the protection of
some other property or cash to be used to protect some other property.”